1 Lecture 4 Historical profitability analysis Valuation models

1 Lecture 4 Historical profitability analysis • Valuation models based on forecasts of net dividends (or theoretically equivalent forecasts), but • Such forecasts must be consistent with our beliefs about future profitability

2 Historical profitability analysis Purpose: • To find ratios useful forecasting future profitability Forecasts: • Sales forecast • Different kinds of ratios • Which ratios?

3 Historical profitability analysis • Operating profitability – – Sales and OI for each segment NOA for the company as a whole • Financial performance – which together with financial leverage determine • Total profitability

4 Operating profitability For each segment (and the company as a whole) we will determine • Rate of sales growth (Sgr) • Core operating profit margin (c. PM) For the company as a whole we will determine • Asset turnover (ATO) • Core return on net operating assets (c. RNOA)

5 Operating profitability NCC – Construction Sweden Rate of sales growth (Sgr)

6 Operating profitability NCC – Construction Sweden Core operating profit margin (c. PM)

7 Operating profitability Two quasi-segments • Discontinued operations • Other and eliminations

8 Operating profitability NCC – Group total Asset turnover (ATO)

9 Operating profitability Technical issue: for all flow/stock and stock/flow ratios, e. g. - ATO = Sales / NOA c. RNOA = c. OI / NOA Use beginning-of-period stock values (not average values)

10 Operating profitability NCC – Group total Core return on net operating assets (c. RNOA)

11 Operating profitability du Pont formula c. RNOA c. OI / NOA c. PM ATO c. OI / Sales / NOA

12 Operating profitability NCC – Group total du Pont formula

13 Operating profitability The company as a whole • Calculate – – Sales growth (Sgr) Core operating profit margin (c. PM) Asset turnover (ATO) Core return on net operating assets (c. RNOA) • Compare with the corresponding ratios for the industry – Convert industry ATO and RNOA to measures with goodwill

14 Operating profitability • Include unusual items to calculate – – Operating profit margin (before tax) (PM) Return on net operating assets (before tax) (RNOA) (final measure of operating profitability)

15 Financial performance • Core borrowing cost (c. BC) • Core return on financial assets (c. RFA) – determine together with the relationship between financial liabilities (FL) and financial assets (FA) • Core net borrowing cost (c. NBC), or • Core return on net financial assets (c. RNFA) – Add unusual net borrowing cost to arrive at • Net borrowing cost (NBC), or • Return on net financial assets (RNFA)

16 Financial performance Core borrowing cost (c. BC)

17 Financial performance Core return on financial assets

18 Financial performance Core net borrowing cost (FL > FA)

19 Financial performance Determinants of the core net borrowing cost c. NBC c. NFE / NFL FL / NFL FA / NFL c. BC c. RFA c. FE / FL c. FI / FA

20 Financial performance Core return on net financial assets (FA > FL)

21 Financial performance • Include unusual items to calculate – Total net borrowing cost – Note that a positive sign in the income statement means a negative unusual net financial expense, and vice versa

22 Total profitability Determinants of total profitability Total profitability Financial leverage Operating profitability Financial performance

23 Total profitability Return on equity (ROE)

24 Total profitability Effective tax rate Return on net operating assets after tax

25 Total profitability Net borrowing cost after tax (NBCat) If the effective tax rate deviates significantly from the marginal tax rate, a more accurate determination of RNOAat and NBCat must be made (see Ch. 3, p. 18).

26 Total profitability Financial leverage (FLEV)

27 Total profitability ROE NI / E FLEV NFL / E RNOA NBC OIat / NOA NFEat / NFL The leverage formula (with RNOA and NBC after tax) ROE 06 = 24, 7% + 0, 06∙(24, 7% – 22, 0%) = 24, 8%

28 Total profitability Minority interest and minority income Calculate • Return on minority income (r. MINT) • Proportion of minority interest (p. MINT)